Understanding collateral

One of the biggest challenges that busy shops face is the need to increase capacity. Beyond running additional shifts, new equipment ultimately is the answer. The next issue that arises is securing funding for the required machinery, which can be challenging for one very simple reason: These are expensive assets, and the funds necessary to make a purchase are not normally sitting in a business’s bank account.

Because income growth shows up on financial statements only after it has happened, it can be tough to find a lender, because they will review the financial history of the company and place little value on future work that requires the new machine.

One of the best methods to attract a lender, particularly in cases where the chosen equipment does not match the applicant’s credit profile, is to provide additional collateral. The use of collateral during financing facilitates a lease approval and gets new equipment on the shop floor that otherwise may be unattainable. This reduces the risk associated with the transaction and, in turn, enables the lender to approve the funding.

Three approaches are common when it comes to collateral.

1. Make a deposit.

When a borrower can’t get financing for 100 per cent of the cost of the machine, offering a lender a deposit is beneficial. It shows that the borrower is serious about adding the necessary equipment and truly believes they will be successful because they are willing to risk some of their own money.

From the lender’s viewpoint, a deposit also mitigates some of the risk of the transaction.

In cases like this, it is likely the borrower is working with an alternative lender that has experience in their industry as opposed to a bank, which typically rejects applications when they do not fit with the borrower’s financial statements and credit profile. A lender that understands machinery and equipment will factor the quality of the asset and its resale value.

If a sizable deposit has been made, an alternative lender knows that even if the deal goes bad and the equipment is repossessed, once it has been resold, a significant amount of equity will be recovered.

2. Use existing equipment.

Even though “cash is king” for many shops, pulling significant funds from working capital typically is problematic, to say the least.

When business is slow, money is tight. But the reality is that even busy shops have cash flow problems because of the cost of labour, material, and tooling, all of which are paid upfront. Also, the time between part production and collecting receivables can be months.

Every shop has a lot of “money” sitting on the floor in the form of existing equipment. This also can be used as collateral. Quality machine tools hold their value over a long period of time. The only problem that can arise when using them as collateral is ensuring that the title of those assets can be conveyed to a lender. This is important because of what is called a General Security Agreement (GSA).

A GSA is presented and signed when a business opens a bank account and operating line. It gives the bank the first chance at all current and future assets of the company in case it closes.

The key word here is future, because over time most companies grow and accumulate assets, with these assets automatically becoming part of the bank’s security through the GSA.

To use any existing equipment as collateral, the bank must first provide a waiver that waives its interest in a specific piece of equipment so that the new lender can use it as collateral.

One strategy to handle these situations is to set up a separate holding company to own assets like machinery and equipment. This is another corporate entity, with an identical ownership structure, that does not have any need for a banking relationship. It is then the holding company that has title and ownership over the assets and, therefore, the ability to use them as collateral when necessary.

3. Use home equity.

Even though it is quite common for a manufacturer to set up its financial statements to show very little profit and ensure minimal corporate taxes are paid, this usually has very little relation to the owner’s actual net worth. In fact, most successful manufacturers normally have strong personal credit profiles and own their own homes, and maybe commercial properties as well.

Property values have risen significantly during the last decade and so have plenty of equity. This means that finding money for a deposit could be just as simple as pulling funds from a home equity line.

Because the property itself is providing the collateral, and the potential lender remains in an equity position, it will be very easy to find a lender to work with.

A better option, however, particularly when working with a leasing company that is familiar with the manufacturing industry, is to allow the lender to put a collateral charge on a property, which has ample equity to cover the transaction.

A collateral charge essentially is a registration with the land title or registry office in the municipality. It would sit in first position or second position behind the first mortgage and provide the required collateral.

The leasing company then arranges for financing of 100 per cent of the equipment’s cost, with more favourable terms, because no deposit is required.

Today’s reality means that adding manufacturing equipment is not a cheap or simple endeavour. These are large-ticket items and require time and effort to both source and fund. It is therefore very important to understand there are options beyond just providing cash to attract lenders, and they usually start with making the best use of assets that have already been accumulated.